Cross-cutting issues
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5.6
Counterparty risk
Counterparty risk is the risk to each party of a contract that the counterparty will not live up to its
contractual obligations.
The effect of counterparty risk materialising is for parties to securities contracts to suffer losses.
During the financial crisis, the materialisation of counterparty risk through the failure of Lehman
Brothers created financial instability as a number of important banks and non-bank financial
intermediaries suffered losses, significantly affecting the overall level of financial intermediation
taking place.
The effect of counterparty risk materialising, may be further counterparty risk as it creates
uncertainty regarding the exposures of banks/NBFIs to a failed institution. This could have
crippling effects on financial intermediation, as the institutions concerned may not be able to raise
funding and thereby extend credit.
5.7
Liquidity risk
Liquidity is a major theme in the debate on risks to financial stability. There are two forms of
liquidity that are important to analysing risks to financial stability posed by NBFIs – market
liquidity and funding liquidity.
Market liquidity refers to the ability to sell or unwind positions quickly without affecting price. A
lack of market liquidity is likely to have an impact on a large number of institutions, so is thought
of as being an important source of risk to financial stability. An asset sale in an illiquid market may
depress the price of that asset, affecting the balance sheets of all holders of that asset. This effect
may be exacerbated if holders of that asset then seek to sell as well.
Moreover, in a leveraged setting and as a result of shrinking asset bases, funding conditions
deteriorate insofar as lenders require higher margins to insure against borrower default, which,
through limiting institutions ability to transact, further compounds the problem of market
illiquidity. This effect is known as a margin spiral (King and Maier, 2009).
The other form of liquidity that is relevant in this discussion is known as funding liquidity. This
refers to the ability of an investor to raise cash to meet its financial obligations and it is specific to
individuals or institutions. A lack of this kind of liquidity is not in itself a risk to financial stability,
however if the institution which is suffering from funding illiquidity is very interconnected, then
the knock-on consequences that result could potentially be a threat to wider financial stability.
Funding illiquidity is a real risk to the continued existence of NBFIs, particularly hedge funds as if
they fail to meet margin calls, they can be declared bankrupt. This can occur even if the fund has
positive equity. Indeed it is usual for financial institutions that go bankrupt to do so as a result of
funding illiquidity rather than insolvency (King and Maier, 2009).
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